Section 2: The Keynesian Model

John Maynard Keynes wrote his most important works, Treatise on Money (1930) and his most famous work, The General Theory of Employment, Interest and Money (1936), around the time of the Great Depression. During the Great Depression, many economists and politicians looked for answers to solve the disturbing output declines and unemployment increases. His economic views led our government to pass the Employment Act of 1946, which established the Council of Economic Advisors and made the federal government responsible to intervene in the economy when necessary.

Before Keynes

The classical economists, whose thoughts were widely accepted in Western economies before the 1920s, and whose theories have recently gained support again, believed that economic downturns can best be solved by leaving the economy alone and letting private market forces correct the problems. A self-correcting mechanism (Adam Smith’s “invisible hand”) is in place, which allows for only minimal government involvement in the economy. The classical economists base their conclusions on assumptions that in a free market, wages, prices, and interest rates are flexible and adjust according to demand and supply of products, labor and other resources, and money in circulation.

The 1930s

As the economic problems grew more serious during the 1930s, interventionist economic theories gained more acceptance. Big businesses and their “robber baron” business leaders began to be seen as the cause of all economic evil. People started to look toward the government for answers. Keynes’s theories provided precisely the fuel that activist-minded economists and philosophers of that time needed to propose government intervention as the solution to economic problems.

Sticky Wages and Prices

According to Keynes, overproduction and under-consumption are the main causes of any economic downturn. If businesses overproduce during one period of time, they experience surpluses and will cut back on their production during the next period. Cutbacks in production are accompanied by layoffs and declining earnings. Keynes did not believe that wages, prices, and interest rates adjust quickly enough in response to declining conditions. He argued that because of unions and increasingly large monopoly-like firms, wages and prices do not fall much when demand decreases. According to Keynes, prices and wages are “sticky” and do not provide sufficient corrections to bring the economy back to full employment.

Government Intervention

During economic downturns, consumer incomes decrease. These decreasing earnings result in less consumer spending. Firms find themselves with surpluses, and they subsequently produce less. This leads to further layoffs and lower incomes. This leads to even less consumer spending. This snowball effect eventually puts the economy into a bad tailspin and perhaps even an economic depression. Keynes stated that the only way to stop the ball from rolling is for the government to intervene by artificially creating demand and raising people’s earnings. This can be done by initiating public works, increasing welfare handouts, or increasing general government spending.

Deficit Spending and Money Supply Increases

Keynes encouraged government politicians to run deficits during recessions (by increasing government spending and/or lowering taxes) or to print money in order to finance these additional expenditures. If the government runs a deficit, it borrows money mainly from domestic and foreign investors by issuing Treasury securities. Treasury securities are loans people make to the government in exchange for interest and payback of the principal at a later time (see also Unit 8). According to Keynes, when government spending increases and/or taxes decrease, the total demand for goods and services in the economy rises, which increases GDP.

If the government chooses to print additional money during a recession, the money supply increases and interest rates decline in the short run. When interest rates decline, borrowing rises. Subsequently, spending rises, and GDP increases. The printing of additional money is done in the United States through the Federal Reserve System and its central banks.

Government Intervention During Expansions

Even though Keynes’s theories focus on recessions and depressions, he also mentioned that if during an expansion an economy is growing too fast, it will cause inflation. In this case, Keynes recommends for the government to do the opposite: decrease government spending, raise taxes, and decrease the money supply. This, according to Keynes, slows down the economy and prevents inflation by decreasing total aggregate demand.

Short Run versus Long Run

Classical economists predict that if the economy experiences problems, prices and wages adjust in the long run. If a recession decreases business profits, businesses lower their wages until profits increase again. If a recession decreases demand, businesses lower their prices until buyers buy again. If businesses and households are not borrowing enough, banks and other financial companies lower their interest rates. Classical economists predict that the economy always achieves full employment in the long run. They believe that as long as there is enough production, businesses will pay enough wages and earn enough profits. This generates purchasing power and enough demand to purchase all products that are supplied and put just the right amount of people to work to create full employment.

Because of sticky prices and wages, Keynes did not believe that decreases in demand lead to lower prices and wages. Instead of lowering wages and prices, according to Keynes, businesses choose to lay off workers. This increases unemployment. Keynes admitted that in the long run, unemployment may perhaps lower wages and allow businesses to hire more workers. However, Keynes wanted short-run solutions. He stated: “In the long run we are all dead.” According to Keynes, help is needed immediately, and the government can provide it quickly in the form of active spending and taxation policies, and via active monetary policy.